Imagine you’re traveling through India when you stop for a quick haircut. Would you pay more or less than you’d pay for a haircut in the U.S.? While the price of

Imagine you’re traveling through India when you stop for a quick haircut. Would you pay more or less than you’d pay for a haircut in the U.S.?

While the price of tradable goods such as say, an iPhone, may remain relatively constant between countries, the price of services can vary quite a bit. In fact, a haircut in India could cost you less than $1.00!

In this video, Alex Tabarrok discusses the Balassa-Samuelson effect, purchasing power parity corrections, arbitrage, labor mobility, and why all of this is important when comparing the GDP and living standards of different countries.

Transcript

So today we're in India to explain, and also to take advantage of the Balassa-Samuelson effect. We'll also be understanding a little bit more about purchasing power parity corrections, and why they're important. So, let's take a look at this mobile phone store and ask them about some prices. Come on!

[Alex] Namaste! [Hello!]

[Shopkeeper] Namaste.

[Alex] So, can you show me one of your nice phones?

[Shopkeeper] Yeah. This is the best one -- the Apple -- the new one, the 7 Plus.

[Alex] 70,000 rupees -- that's about 1,000 dollars -- at least as much, maybe a little bit more than you'd pay in the United States. And that makes sense, because this good is easily tradeable. Tradeable goods sell for about the same price everywhere in the world. Because if it were a lot cheaper here, people would buy it here, and sell it in the United States. Arbitrage means that goods which are easily tradeable -- they sell for about the same price everywhere.

Now the situation, however, is very different when it comes to services. Services are hard to trade. And that means that the price of services, the price of labor -- it can differ a lot in different places in the world. In fact, I think I need a haircut! Let's go!

[Alex] Namaste!

[Barber] Hello, how are you, sir?

[Alex] Good. Haircut today.

[Barber] Please come sit down.

[Alex] Great.

[Barber] Thik h sir. [It's fine sir.]

[Alex] Achchha! [Good!] Yah. Dhanyavaad. [Thank you.]

Well that was a good haircut, and an excellent head massage. And it cost me just 50 rupees. That's less than a dollar in the United States.

Raju is just as good a barber as any in the United States, but he earns a lot less. Raju might like to come to the United States and sell his labor for $10 an hour instead of the $10 a day or less that he earns here in India. But labor is immobile. A host of laws prevent him from moving. As a result, the price of labor can be very different across the world, and that means the price of services that are immobile -- not just haircuts, but also housecleaning, taxi services, massage services -- they're a lot cheaper in poorer countries.

The fact that services are cheaper in poorer countries is often called the Balassa-Samuelson effect, after Béla Balassa and Paul Samuelson pointed out this fact and developed models to explain it at a deep level.

The fact that services are cheaper in poorer countries also means that, on average, prices are lower -- the price level is lower. That means that each dollar has greater purchasing power in a poorer country. And so if we want to compare GDP, or if we want to compare living standards across countries, we've got to take into account the differences in purchasing power.

And that leads us to our next video on purchasing power parity corrections. Dhanyavaad.